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Why we should care about Deutsche Bank’s losses even though they took place years ago and weren’t real

What to make of the Dec. 5 Financial Times report that German behemoth Deutsche Bank inaccurately accounted for large derivatives positions it held during the financial crisis, thus making it look healthier than it was? The report is based on claims by three of the bank’s former employees:

All three allege that if Deutsche had accounted properly for its positions—worth $130bn on a notional level—its capital would have fallen to dangerous levels during the financial crisis and it might have required a government bail-out to survive.

Instead, they allege, the bank’s traders—with the knowledge of senior executives—avoided recording “mark-to-market”, or paper, losses during the unprecedented turmoil in credit markets in 2007-2009.

The SEC is investigating the allegations. Deutsche Bank’s response to the FT story is that these claims are over two and a half years old and had been previously reported publicly. The bank added that it had been the subject of “a careful and thorough investigation”, adding that the allegations were “wholly unfounded.” The losses would have only been on paper anyway. And at any rate, it’s going on five years since the financial crisis hit. Deutsche Bank didn’t go under. And so some people are asking, “Should we really care about this now?”

Well, yes. If only because it opens up another chance for people to truly see how truly dumb the financial world was in the run-up to the crisis.

This was especially true of some of the most complicated products the banks sold—and investors bought—hand over fist during that era. By and large, bankers don’t like explaining the ins and outs of those complicated products. In part, that’s because quite a few of them don’t understand the deals all that well. But it’s also because if they did explain them in short, common-sense terms, people would be terrified. And as we found out in 2008, the financial system does not function well when people are terrified.

Look at it as insurance, not investments

The nub of the FT’s report is this. Three Deutsche employees separately complained to regulators that the bank was not properly showing how much it could stand to lose if some of its trades went against it. By doing so, the paper reported, Deutsche may have hid up to $12 billion in paper losses during the worst of the crisis.

The standard debate about how just bad this is comes in two parts. First, it’s about accounting: Is that $12 billion the right figure? “Marking to market”—i.e., working out what the trades were actually worth—is a notoriously hard thing to do with complex financial instruments in the midst of a crisis. No one was buying and selling those products. And with no one buying and selling there is no market to mark to.

Second, there’s whether it matters. These are only paper losses, meaning it’s not cash that ran out the door, it’s cash Deutsche could have lost if it had been forced to sell right then and there. It wasn’t; it didn’t; and now it’s healthy again—apparently. Some, like Reuters’ Felix Salmon, therefore argue that even if Deutsche did mis-state its positions, perhaps it’s just as well, because had it announced a $12 billion loss it could have ended up like Lehman Brothers and that would have been disastrous for the entire financial system. Over at Deal Breaker, ex-banker Matt Levine offers a similar thesis. The upshot: Whether this is accounting fraud is unimportant. And even if it was important, it would be pretty much impossible to prove because nobody knows what any of this is stuff is worth anyway.

But I want to focus on something else. It’s what these kinds of trades actually represent.

The deals in question are something known as ”leveraged super senior” trades. In the simplest terms, the bank says to an investor, ”Have we got a deal for you! We’ll agree to pay you a series of fixed payments based on the performance of a basket of assets. If anything goes wrong, you’re going to help protect us by coughing up some cash. But don’t worry, nothing will go wrong. These are senior parts of these assets. That means we’re the first to get paid. In fact, they’re super senior. In other words, we’re at the front of the line of people who are already in front of everybody else. These are bulletproof, seriously. Trust us.”

In other words, one way to see this is as the banks selling investment instruments to investors. But the other is to see the investors as selling insurance to the banks. As long as the assets are safe, the insurer (investor) makes money. But if something happens to the assets, the insurer pays out.

Now, at the time, these insurance policies were written on stuff that was considered some of the safest stuff available. The December 2006 edition of Futures and Options World clearly stated that the slice we’re talking about was safer than safe. “The leveraged super senior tranche is better credit risk than AAA/Aaa,” they wrote.

And indeed, this isn’t the usual Wall Street crisis story you’ve heard before, where it turned out that the banks were wrong and that AAA stuff was really just junk and investors ended up on the hook. Those supersafe slices that weren’t supposed to go bad—they indeed did not go bad. And investors (insurers) never had to cough up, according to Deutsche.

So what’s the problem?

The problem is the entities acting as insurance companies here… aren’t insurance companies.

For one thing, insurance companies are forced by regulators to sock away tons of cash to cover them in case that hurricane actually hits and they have to pay a flood of claims. Investors in the Deutsche trade did put up some collateral that in theory should help handle some payouts—but not much. The FT reports that “on a typical deal with a notional value of $1 billion, the investors would post just $100m in collateral—a fraction of what would normally be posted by an investor writing an insurance contract.” In fact, it was widely understood that if losses did materialize, the investors would likely turn their back on the deal. That assumption is known as “gap risk.”

In short: Deutsche Bank appears to have bought insurance that was practically guaranteed to vaporize the moment it looks like it was needed.

Felix Salmon says that the question then becomes: What does Deutsche Bank tell its investors about this weird insurance it bought? Does it say it will cover their potential risk? Has it made other bets in the financial system (i.e., hedges) that will cover it if its phony insurance does disappear? Did the whistle-blowers know exactly how much the risk the bank was facing? Did Deutsche? (Short answer: No! They’re all just playing around with a bunch of semi-educated guesses and assumptions. Which sound far more respectable when you are well-dressed, have access to a lot of impressive look charts and use phrases like “marking to model.”)

But to me, this all misses the point, which is: Don’t let investors sell phony insurance that goes away when you need it. And don’t let banks buy it.

The fact is, nobody knew or knows how much protection those products offer. They only let the banks delude themselves into the believing they could master all risk. They confuse regulators and everybody else. And because of the vast web of bets and counter-bets designed to “mitigate” these incomprehensible risks, it only ties the financial sector closer together, so that one big blowup risks infecting the entire global financial system.

We’ve seen again and again that these kinds of products, derivatives, are indeed financial weapons of mass destruction, as Warren Buffett warned. (Although he also owned a bunch of them.) But I think there’s a more apt name: phony insurance contracts of mass destruction. They brought down insurer AIG, after its London-based financial products division agreed to play insurer without socking away anything resembling the amount of money it would need to pay claims.

The Dodd-Frank financial overhaul makes a big push towards trying to clean up the world of derivatives, including forcing many of those bets on to the clearing-houses. This would, in theory, lower the risk of any one financial entity setting off a string of collapses because of a bad bet. But the law really isn’t in final place yet.

In fact, the SEC just recently proposed new rules that would force the entities that buy and sell derivatives to set aside the cash they need to meet their obligations. There are likely an army of bank lobbyists working on weakening that provision right now. Why? Because the more money you have to set aside, the less potentially profitable a winning trade would be.

So if this Deutsche Bank story serves to remind people how difficult to manage and destructive these financial playthings may ultimately be, that’s a good thing.